Q&A Forum

Should discretionary bonuses be accrued?

Client wishes to accrue the entire amount of a merit pool at the end of the year in which it was established. The reasoning to support the accrual is that the awards were presumably “earned” in that year because the awards will be based on performance rendered in that year. However, any awards will be determined and paid in the subsequent year based on subjective criteria, such as the significance of an employee’s contribution. The awards are NOT based on objective performance goals such as exceeding sales targets. And the company is not contractually or legally obligated to make any awards. In fact, per the merit pool guidelines, “The final decision regarding the granting of the awards and the amount of any such award will be at the discretion of the CEO who reserves the right not to grant any awards in a given year.” I believe a unilateral bonus of this nature should be recorded on the cash basis. The bonus is completely discretionary; there is no legal obligation to make any payment; and therefore no basis to record a liability. Furthermore, the awards are based on subjective criteria that do not permit the computation of a reasonable estimate. I found a tax ruling that supports my logic (Regs. Sec. 1.461-1(a)(2)), but I haven’t found a specific GAAP reference. Does one exist? What is the correct GAAP treatment?

Answers

If the factors leading to the discretionary bonus occur in the current year you should accrue in the current year. When in doubt, I have always accrued but you should also look at the pattern of payouts in prior years. As for tax treatment, make sure you pay it out 2.5 months after the fiscal year ends or you won't get the deduction until the following year.

Based on the fact pattern you provided, these should be accrued based on the year that they were earned. In other words, the accrual basis of accounting would be used. You may have to force your CEO to review these before you close the year end in order to get an accurate accrual. As Lyle mentions, you have to pay the bonus within 2.5 months of year end and have no other contingencies on these payments in order to take the deduction.

I agree with the previous responses. The bonus should be accrued monthly during the current year, with the accrual adjusted for known changes in circumstances (i.e. employees leaving the company or new employees hired).

Are you budgeting (or did you) for them? Have an idea of the total amount of awards? At the end of the day, the reason, criteria and amounts (per individual) of the award are NOT relevant. The only thing that matters is the LIKELIHOOD OF DISBURSEMENT/EXPENSE and what total amount. Estimating the amount/s (as others have recommended) is up to you as a company, available data, and how strong is your company's financial resolve to stick to the budget. Example...you may have budgeted for and accrued for christmas bonuses, yet there is NO guarantee nor legal obligation that you will/should award them.

I had a similar situation at a client: execs were hired during the year and offer letters included significant bonus potential. However, formal plans were never written in part because company operations and objectives changed significantly during the year. Decision on any bonus payouts rested with the Board, primarily outsiders, but the company president and I both felt they would agree to pay something so we recorded an accrual. The company's books were audited but as of the time of the audit, the Board had not discussed the issue. End result was Auditors agreed we could record an accrual based on our judgment that a payout was likely.

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